John Maynard Keynes
It turned out Keynes had many ideas, unfortunately, some of them turned out to be bad ones.
It is November and The Golden Sense is celebrating its first anniversary! I have had a tremendous amount of fun spinning my wheels writing about personal finance, world economics and psychology. I have received a huge amount of interest and support. The original vision of The Golden Sense was to get my generation of young Americans interested and queued in on personal finance and the world around them. My vision remains the same for the future.
I have noticed The Golden Sense has not only been followed by my peers but from people of all ages. I have to say the conversation of money and the world we live in should be interesting no matter how old you are.
The Golden Sense is free and I intend for it to stay that way for the time being. My marketing capacity is limited. Most readers hear about it through word of mouth. I don't expect everyone to agree with the idea's that are presented, but the purpose of each post is to spark one's thinking and make them consider their own financial situation in the world they live in.
The Golden Sense is about logic, research, and ideas. The goal is to bring this to forefront of every reader's life.
I recently wrote a paper for a banking professor. I felt the professor was very much "by the book" and engulfed with status quo. Her trust in the status quo surprised me. So I decided to submit the following paper and hopefully make her reconsider:
Title: Fiat Money
By: Todd Norman
(please keep in mind that this is a Masters Degree level paper intended for a college professor.)
Introduction
There have been many different types of monetary systems throughout history. The payment system has been evolving over centuries and with it the form of money. Throughout history people and nations have used the barter system, commodity money, fully backed paper money, and now a non backed fiat money system. At this point, none of them could be labeled as perfect. In the present day world of 2011 non backed fiat money systems are widely used. This paper will focus on the fiat money standard and its three major flaws. The United States, Japan, Europe, and China all use a non backed fiat money system. Most lead economists for central banks see the system as a necessity and would gaff at returning or changing the way in which money is issued. However, there is growing number of economists who are now looking at the very issuance of our money as our fundamental problem. Fiat money is a paper currency issued by Governments as legal tender and is not convertible into coins or precious metal. Governments issue laws that require this fiat money to be accepted as payments for debts. The only thing that gives the money value is its relative scarcity and the faith placed in it by the people that use it. The United States used to be on a monetary standard where all notes were redeemable in gold and silver. However, in August of 1971 President Nixon ended the international gold standard and for the first time no currency in the world had a gold backing. The U.S. has been on this fiat standard for the last 40 years. This was not the first time the fiat standard was used. Fiat money has been tried and tested in the past and in all cases failed as a lasting currency. The current system has had troubles and the weakness in fiat currency has reared its head once again. The three major problems that a fiat money standard has are the lack of political and fiscal responsibility, currency devaluation, and the prominence of booms and busts.
Political and Fiscal Responsibility
The very nature of political and fiscal responsibility lies within human action. On a fiat money system the issuance of credit can be created at any time. Since fiat money has no backing except for the full faith and credit of those who issue it, there is always the problem in regards to the respectability and responsibility of those who are controlling the money supply. There is an old saying that “all power corrupts”. Politicians and central bankers have the ability to issue credit or expand the money supply whenever a “problem” arises. This power is eventually misused due to human nature.
The Federal Reserve issues the currency in our country known as the U.S. Dollar. Although national monetary events may appear mysterious and chaotic, they are governed by well established rules which bankers and politicians rigidly follow. The central fact to understanding these events is that all the money in the banking system has been created through the process of making loans (Griffin). The problem or misuse arises when Governments overspend. In the United States’ case they overspend and seek loans from the Federal Open Market Committee. There are other times when Federal Reserve or the central bank is politically forced into acting as the lender of last resort. The following are a few examples of when politicians and Federal Reserve have acted as the lender of last resort.
In 1970 Penn Central railroad became bankrupt. The Federal Reserve bailed them out through the use of Government subsidies and bank loans. Congress was told that the collapse of Penn Central would be devastating to the public interest. So congress acted and a $125 million bailout was complete. Penn Central eventually became AMTRAK and continues today to operate at a loss. In 1972 the Commonwealth Bank of Detroit was given a $1.5 billion dollar bailout due to bad lending practices. It was said that it was in the interest of the public that the bank should be supported. In 1975 New York City essentially became bankrupt due to its extravagant bureaucracy and miniature welfare state. Congress was told that the public would be jeopardized if city services were curtailed. A $2.3 billion bailout arranged through the help of politicians and the Federal Reserve. In 1978 Chrysler was on the verge of bankruptcy. Congress was informed that the public would suffer greatly if the company folded. A $1.5 billion bailout was made available. In 1979 First Pennsylvania Bank almost failed. A $1 billion line of credit and hundreds of millions of dollars were created to save this bank. In 1982 Chicago Continental Illinois became insolvent. $4.5 billion in bad loans were covered up. The bank essentially became nationalized (Griffin).
All of the bailouts of previous years are pale by the comparison to the trillions of dollars pumped into the banks in 2008 in response to the subprime meltdown. Lehman Brothers was allowed to fail along with thousands of mom and pop stores throughout the U.S. Yet the Troubled Asset Relief Program ensued and in other instances AIG, Goldman Sachs, and General Motors got propped up with the issuance of credit and support from politicians and Federal Reserve. These moves may have seemed necessary, however the competitors to these bailed out companies would say otherwise. This use of expanding large amounts of credit could only be made possible on a fiat money standard. Under other monetary standards such as the price pegged gold standard, the issuance of credit could not have gone this far. Under the fiat standard lending practices and unrestrained use of credit allows corruptions, favorites, and over leveraged companies to seek solace in the arms of U.S. Government and Federal Reserve.
The fiat standard has always been the choice the monetary standard during times of war. Politician want a fiat standard so they can use the excessive creation of money to wage war and use it for Government purposes. During the early 20th century Governments went to fiat standard in order to wage war. "The first thing that happened in the financial sphere upon the outbreak of the World War I was that the existing gold standard was abandoned— not only in the belligerent countries but also in the majority of neutral states. Upon the entrance of the United States into the War, corresponding steps were taken in that country" (Preston). Besides the obvious problems that war brings about, the biggest problem from a monetary standpoint is the devaluation of the currency when the money supply is increased. This essentially causes a problem for creditors. There is a great example during the World War time period in Europe. “The greatest burden of devaluation has fallen upon War and pre-war creditors. Pre-war internal debts were reduced approximately four-fifths at the expense of the creditors. This was especially significant in France because the French people have long been noted as a nation of savers. The net amount of French foreign investments was estimated at approximately 38 billion Francs at the outbreak of the War. Her public debt was over 34 billion Francs in 1914; by December 31, 1918, it was 124 billion” (Preston). By moving to a fiat money standard politicians can easily wage war without restraint and put the expense on the creditors through the process of devaluation. Whether the Government is fighting communism, a dictator, or spreading “democracy” throughout the world, being on a fiat money standard makes a war that was once financially impossible now seem possible.
Fiat money is a problem because it is political money. The problem exists by the way the money makes its way through the economy. When the Government inflates the money supply, the new money does not reach everyone proportionately or at the same time. It enters the economy at discrete points. “The earliest recipients of the new money include politically favored constituencies of one kind or another: banks, for example, or firms with government contracts- in other words wherever the government spends money. These privileged parties receive the new money before inflation has pushed prices higher. In effect, the economy doesn’t yet know how much the money supply has increased, and prices have not yet adjusted accordingly. By the time the new money makes its way through the whole economy, prices will have risen throughout practically all sectors. But while this process is taking place, the privileged firms that are lucky enough to get the new money early benefit from being able to make their purchases at the previously existing price level- thereby silently looting those from whom they buy. When the average person gets his hands on this new money- through higher wages, say, or lower borrowing costs, prices will have already been rising for quite a while, and he has been paying those prices all this time on his existing income” (Woods). The value of his money has gone down by the new money before it has reached him. The fiat standard causes unwanted Government growth, constituencies, and a privileged society because of its ability to inflate the supply.
Currency Devaluation
Currency devaluation is the loss in purchasing power of a nation’s currency. It is most often subtle and unnoticeable to the average folks. Operating on fiat money standard runs the risk of bad inflation. Currency devaluations occur because of inflation. Inflation is sometimes referred to as the rise in prices. However, inflation is actually the increase in the money supply itself. This in turn leads to higher prices. Under a fiat standard that the world currently uses, inflation can be defined as an increase in the amount of paper money in circulation. If the fiat standard is misused, inflation will devalue the money. In the past, currency devaluation and hyper inflation has caused real hardship on certain economies.
One of the world’s most devastating inflations took place during the French Revolution of 1790 to 1796. “The Reign of Terror Revolutionaries made it their first order to issue paper money without any gold or silver backing. They issued assignats. One wave of paper money led to the next. Gold and Silver coins disappeared from circulation. The French inflation was accompanied by all the disastrous economic policies imaginable: wage and price controls, currency repudiation, and the wholesale redistribution of wealth and disregard of property rights. Penalties for violating the economic edicts of the government’s central planners were severe, including generous applications of the guillotine” (Goyette). David Dickson White wrote about the extremes the Government went to in order to force fiat money onto the French people. “Anyone who refused to accept a payment in assignats, or accepted assignats at a discount should pay a fine of three thousand Francs.” The people of France wanted their money to be backed by gold. “The only things transmuted in France were prevailing in poverty. From 1790 to 1795 a measure of flour had raised from 2 Francs to 225; a pair of shoes from 5 Francs to 200; a pound of soap had risen 44 times in price; a pound of sugar 70 times. Even so, the wages and rewards of the productive plummeted, while gamblers and speculators profited. In less than 6 years the Revolutionary Government of France had issued 45 billion Francs of paper money. One Franc of gold was worth 600 Francs of paper. And out of the ashes of the economically destroyed France arose the dictator Napoleon and his seventeen years of war, empire, and bankruptcy” (Goyette).
The issuing of fiat money helped lead France to one of it all time worst time periods in history.
Germany had a horrible bout of hyper inflation as well. World War I ended in 1918. “The ruinous reparations imposed (such as the blockage of food shipments) on Germany under the Treaty of Versailles were initially 269 billion gold marks. That’s about $2.8 trillion at recent gold prices today” (Goyette). The Allies wanted gold while the German people were forced to receive non backed fiat currency. In 1918 at the end of the war there were just over 22 billion marks in existence. By November 1923 there were over 518 quintillion marks in circulation. The price of an egg had gone from a quarter of a mark at the end of the war to 80 billion marks in November 1923. The economy was left in shambles. Out of the ashes of the destroyed German economy and the smoldering resentment of the people arose the National Socialist Workers Party, the Nazis, and the advent of Adolf Hitler (Goyette).
In recent years the same tale of fiat money corruption is alive and well in Zimbabwe. 10 years ago inflation in Zimbabwe ran at about 32%. In 2008 the countries official inflation numbers ran at 231 million percent. Today they are all billionaires who can afford to buy nothing. The country is in complete poverty over run by a cruel government. “Robert Mugabe, Zimbabwe’s president, has to keep the money flowing to pay off the militias and the thugs who keep him in office” (Goyette). It shows that the survival of the government trumps the well being of the country’s economy and the well being of its people.
Under the three hyper inflation episodes explained it showed that the Government used a fiat system to take wealth from their own people and use for Governmental purposes. Even our former chairman of Federal Reserve, Alan Greenspan, once wrote about the dangers of a fiat standard in his book “Gold and Economic Freedom”.
“In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.”
Ironically, Alan Greenspan later became chairman of the Federal Reserve and actively increased the money supply under his chairmanship.
The United States operates under the Federal Reserve System. In 1971 the USA converted to a non backed fiat standard. Since the creation of the Federal Reserve in 1913 the U.S. dollar has lost 95% of its value. Any person who saved actual dollars for the last 100 years would be at almost a total loss.
Within the last few years the Federal Reserve has increased its balance sheet significantly. Under their program quantitative easing round two they purchased $600 billion worth of U.S. treasuries. This is essentially an act of expanding the money supply. The effects of rising prices have hit certain sectors. For instance commodity prices have risen substantially in the past three years. Precious metals such as Gold have more than doubled in price since 2008. Even the Governments CPI increased 3.9% in the third quarter of 2011.
Even though the rest of the world is operating on a fiat standard, the U.S. has increased its money supply significantly in comparison. The U.S. dollar index chart of the past decade shows a declining dollar against six other major currencies. This is a huge loss of purchasing power to the American consumer.
In recent history the United States has used its power to increase the money supply via the Federal Reserve because the powers at be employ a Keynesian method to their central economic planning. The basic Keynesian Formula consists of the following make-up: C + I + G + X − M = Y(GDP). By using this method they have increased Government spending as well as increased the money supply during times of economic and GDP downturn. The economy however, has not responded in the way many expected. The negative aspects of increasing the money supply such as soaring commodity prices and the uptick in the Governments CPI are taking a toll on the average American.
Many economists today (many with connections to the Federal Reserve) often think as inflation as necessary for economic health. The problem is that inflation can easily get out of control and cause real hardship and the loss of wealth for the average American.
Boom and Bust Cycle
A fiat monetary standard helps create a boom and bust cycle that is much bigger and destructive than a regular business cycle. Boom and bust cycles are not inevitable and would not occur were it not for the inflationary monetary policies that always precede recessions. Ludwig von Mises and Friedrich Hayek of the Austrian school view recessions as necessary to correct the artificial booms that preceded them. Friedrich Hayek won the Nobel Prize in economics in 1974 for a theory of the business cycle. In light of the 2008 crises which so many economists are at a loss to explain, Hayek’s work finds the root of the boom bust cycle in the central bank. In our case it is the Federal Reserve, the very institution that says they are the protector of the economy and source of relief from the business cycle. Booms and busts are said to be started by the issuance of easy credit and inflation under a fiat monetary system. “Such booms, created by inflation, send false signals the capital markets that there are additional savings in the economy to support higher levels of investment. These higher levels of investment, however, are not authentically funded because there has been no actual increase in savings. Ultimately, when the mistakes are revealed, the malinvestments, as Mises called them, are liquidated, creating a bust. Legitimate economic expansions, financed by actual savings, do not need busts. It is only the inflation induced varieties that sow the seeds of their own destruction” (Schiff). Bad investment can occur at all levels throughout society from individuals to big corporations. “When the currency is not a stable unit of accounting, when the central bank creates credit conditions by monetary manipulation, people and businesses make decisions in ways they otherwise would not” (Goyette). During the 1990’s Alan Greenspan held interest rates lower than the market would have set them. At times the interest rate hit 3%. At the turn of the century the tech bubble burst. After 9/11 interest rates were held down and at times hit 1%. The money supply expanded. Five years later the housing bubble burst. These bubbles and busts can be seen through the stock market action of the Dow Jones Industrial average. A chart of the Dow dating back to 1974 is below.
“According to the Austrian business cycle theory, the business cycle unfolds in the following way: Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable "credit-fuelled boom" during which the "artificially stimulated" borrowing seeks out diminishing investment opportunities.” This boom is sometimes interpreted incorrectly by economists and mistakenly seen as real growth. “This boom results in widespread malinvestments, causing capital resources to be misallocated into areas which would not attract investment if the money supply remained stable. Austrian economists argue that a correction or "credit crunch" – commonly called a "recession" or "bust" – occurs when credit creation cannot be sustained. They claim that the money supply suddenly and sharply contracts when markets finally "clear", causing resources to be reallocated back toward more efficient uses.” http://en.wikipedia.org/wiki/Austrian_School
Under a fiat standard it is easy to expand credit at will. Economies tend to overheat because demand is abnormally strong, shifting the demand curve past that kink in the aggregate supply curve. In other words, the equilibrium point has shifted past that point that economists call potential output. When they try to meet this higher level of demand, producers' costs increase sharply. Now, prices are increasing more rapidly than output. It then could head into an inflationary spiral, one of the types known as demand-pull inflation. This type of overheating can be caused because of loose and large expansion of credit and monies.
Today, the United States and the Federal Reserve operate with a loose monetary policy. Credit is made available with low interest rates and borrowing is encouraged while saving is discouraged. Only under a non backed fiat system could such large amounts of credit be issued. As Austrian economics state, booms and busts prevail with this type of economic planning.
Conclusion
It is clear that fashionable opinion does not want to discuss the very issuance of money in connection with economic crises. Political recklessness, inflation, and booms and busts are often blamed on anything but our monetary standard. Whether it is academics, the media, or our policy makers the discussion of money is often put in a corner. However, questions should be asked. Is the fiat monetary system the best way forward? Is our system really that great when it has caused our dollar to lose 95% of its value? Is it desirable for our government to be able to create out of thin air however much money it needs, thereby enabling it to avoid the more obvious routes of taxation and borrowing and instead taking wealth from the people in a less obvious manner? Could a system that does not allow the Federal Reserve or the government to manipulate the money supply and give rise to booms and busts be more stable than the one we have now? (Woods) These questions are scary and go against popular thinking. The fiat monetary standard is nothing new. It’s been tried throughout history. Each time the standard has led to economic turmoil and ruin. It appears that our nation is heading down the wrong path with our current system. Change would be difficult when there is so much is at stake. As always, no one can say it better than Thomas E. Woods: “You don’t win friends in the political and media establishments by proposing a monetary system that cannot be exploited by governments to enrich their friends, enable their addiction to spending and looting, and fund their bailouts. But when you ask a question that sends respectable opinion into hysterics, that’s often a sign you’re on the right track.”
The End
References
Goyette, C. (2009) The Dollar Meltdown. Penguin Group, Inc. New York, NY
Griffin, E. (2008) The Creature from Jekyll Island. American Media. Westlake, CA
Mishkin (2010) Money, Banking & Financial Markets. Pearson Education, Inc. Boston, MA.
Preston, H. (2009) Europe’s Return to the Gold Standard. Harvard Business Review
Schiff, P. (2007) Crash Proof. John Wiley & Sons, Inc. Hoboken, NJ.
Woods, T. (2009) Meltdown. Regnery Publishing, Inc. Washington DC.
